Money-market mutual funds have long been one of the world's most popular investment products, and why not? For 40 years, they offered better returns than bank deposits, were just as accessible and seemed just as safe. That is, until September 2008 when Reserve Primary Fund, the oldest U.S. money market fund, collapsed, spurring a run on other funds. In the wake of that panic, the U.S. Securities and Exchange Commission in 2014 passed rules aimed at protecting investors in a crisis and making the financial system more resilient. Even before the rules take effect, they have already reshaped the money market industry — in ways some think will increase risks instead of tamping them down.
The rules take effect Oct. 14, but since they were announced, the number of U.S. money market funds has shrunk to 369 from 560 and a number of the biggest ones have stopped investing in anything other than government or government-backed securities. Only that category of funds will be allowed to continue the industry's cherished practice of pegging the price of fund shares at $1. What are known as prime funds,, which cater to institutional investors and buy short-term debt issued by banks, companies and municipalities, will have to let their share price float to reflect fluctuations in the value of those loans. Ahead of the change, investors have been shifting tens of billions of dollars out of such funds, which have been hoarding cash to prepare for further withdrawals. All this has been squeezing credit and raising worries about more market turmoil as the changeover day approaches. In Europe, where funds have always split between those with constant share prices and those whose prices floated, regulators are completing rules that would tighten up risk management and require funds to invest in more liquid assets.
Money market funds were born in 1971 as an alternative to bank deposits, whose interest rates were capped by the government. Keeping share prices fixed at $1 — known as constant NAV, for net asset value — was seen as crucial to the field. It made the funds seem more like banks. But $1 deposited in a bank is always worth $1 — it's a loan which the bank is obligated to repay and which federal deposit insurance guarantees. An investor who puts $1 into a money-market mutual fund is buying a share of a pool of loans made by the fund —loans whose value can go up or down. When the Reserve Primary Fund "broke the buck'' —had to admit that its investors had lost money — it triggered the equivalent of an old-fashioned bank run. Because money-market funds are the largest source of short-term credit for banks and big companies, their woes threatened to worsen the financial crisis. Only a federal bailout that put taxpayers on the hook for trillions of dollars saved the funds, and the broader credit markets. That left regulators determined to take steps later to reduce the funds' systemic risk. The industry succeeded in blocking the original SEC proposal to ban constant fund prices altogether. In the final version of the rules, the agency also gave funds with floating prices the right to limit or penalize withdrawals in times of stress.
The industry fought against the broader ban on constant-value funds by arguing that other changes required by the SEC had addressed safety issues. It also warned that a floating share price or withdrawal limits could drive away customers or create upheaval in the $1 trillion market for commercial paper. Some fund executives see the current market changes as proof those warnings were right. Other investors see the stresses as temporary. More lasting, however, may be the shrinkage in the amount of investor money the funds are able to make available to banks and corporations. If that hampers their ability to grow, it could be a case of unintended consequences. If it means that fewer trillions are at risk during the next market downturn, regulators could consider that a price worth paying.
The Reference Shelf
- A research report by BNY Mellon comparing the U.S. and EU proposals and an analysis from lawfirm Stradley Ronon on the new U.S. rules.
- The EU’s proposal for regulating funds.
- While Schapiro was preparing her plan, the Investment Company Institute addressed the question, “Do Money Markets Pose Systemic Risk?”
- After the Schapiro plan died in August 2012, the Financial Stability Oversight Council prepared its own recommendations for money-market fund reform.
First published April 22, 2014
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